Many founders launch their startup with the goal of eventually exiting the business and generating a capital return. Others don’t – their startup is their life’s work. Although we can be sure of one thing – every investor invests in a startup to generate a capital return. You then need to plan for a future liquidity event of some kind. The three options are (i) a trade sale, (ii) an IPO or (iii) a secondary investor buyout. This article will explain what each of these terms means.
The most common way in which startup founders and investors achieve an exit is through a trade sale. This generally occurs where a competitor or strategic acquirer decides that acquiring the startup in question makes strategic sense. There are two ways in which a trade sale can occur:
- Asset sale: Where all the startup’s assets that are sold are transferred to the acquirer, but the company’s shares are not; and
- Share sale: Whereby the buyer purchases the shares in the company from the startup’s shareholders.
The startup’s shareholders will typically prefer a share sale structure while the acquirer will usually prefer an asset sale. These differing priorities are because during an asset sale, the company’s liabilities will remain with the seller while a share sale will ensure that they are transferred along with the shares (although the seller will, of course, be required to provide certain warranties).
In any case, most reasonable startup exits will be structured as a share sale as this is standard practice. Usually, only smaller businesses (e.g. cafes and salons) are sold through an asset sale.
Initial Public Offering (IPO)
An initial public offering (IPO) is another way for shareholders to exit a business. Obviously, the number of startups who get to the stage where a listing makes sense is quite small. The great thing about an IPO is that it opens up the most liquid funding source to a company – the public markets. There are however numerous downsides. The market reacts swiftly to bad news, which means you need to prepare for this eventuality. There is a significant cost to listing, both regarding upfront fees for lawyers and advisors, and also in terms of ongoing compliance costs.
It’s worth noting that there’s a significant difference between a very early stage listing on the ASX, which is generally designed to raise capital for a startup’s expansion and/or development plans, and a later stage listing designed to provide a capital return to investors. The later are much less common, and realistically your startup will need to be profitable before a listing designed to return capital to investors will make sense.
Investor Secondary Buyout
In certain circumstances, some investors will want to exit their investment and get a return, while others won’t. It’s not uncommon to see one group of investors buy out the shareholding of another group. This rationalises the shareholder base and provides an exit for those investors who have a shorter time horizon or are more comfortable operating at the early seed stage of the market. In certain circumstances, when an investor wants to take on a larger shareholding in the company, there may also be an opportunity for founders and potentially employees to sell down some shares or options.
Do you really want an exit from your startup? The grass is perhaps always greener, but what are you going to do next? Many entrepreneurs never plan on exiting their business. In fact, many venture capitalists prefer to invest in businesses run by founders who are never planning on exiting. This doesn’t mean your investors (if you have investors) won’t want an exit. Most will. Having said that, if you build a profitable company that begins paying significant dividends an exit may not necessarily make sense. Have a good think about what you, your investors, your employees and your customers would actually get out of an exit and work out whether one makes sense.
If your startup is successful, and particularly if you raise external capital to fuel growth, you’ll need to think about whether an exit makes sense. Personal considerations will, of course, come into play, as will the investment horizon of your investors. Market conditions are of course always an important factor. Whether you look to a trade sale, an IPO, a secondary investor buyout or choose not to exit, make sure you seek advice from experienced professionals. Questions? Get in touch with our startup lawyers.
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